October 22, 2014

Does government spending have a multiplier effect on the economy?

If I didn’t lose you with that wonk-ish sounding title, there’s a good possibility I’ll lose you a little later, so let me summarize: new research suggests that government spending doesn’t actually help the economy all that much.

Bear with me as I explain.  Some economists of the Keynesian persuasion believe that in a recession the economy is really facing a demand and supply problem, and that the way to get a depressed economy going again is to increase the demand for products and services. Accordingly, governments should enact policies that increase demand, which would in turn provide increased employment to meet that demand. To do that, governments should spend money, on roads, on dams, even, according to theory, on digging holes. That worker will then go out and spend that money, providing further cash to businesses that will hire more workers, spend the money on wages, and so on.

Spending to recovery, is how it has been called. The money that the government inputs to the economy is said to have a “multiplier” effect, because as it is circulated its effect is multiplied. Conventional wisdom, then, is that the more money the government gets spent, the more it does to boost the economy…which is why we’ve seen so much “stimulus” talk in recent years. The money is supposed to stimulate the economy.

But what if the conventional wisdom was wrong? What if there is little, or no, multiplier effect? (and here is where I think I might lose you, again):

Research published in November of 2010 is indicating that there is very little multiplier effect. From the abstract of “In Search of the Multiplier for Federal Spending in the States During the New Deal,” by authors Price V. Fishback and Valentina Kachanovskaya:

If there was any time to expect a large peace-time multiplier effect from federal spending in the states, it would have been during the period from 1930 through 1940 when unemployment rates never fell below 10 percent and there was ample idle capacity. We develop an annual panel data set for the 48 continental states from 1930 through 1940 with evidence on federal government grants, loans, and tax collections and a variety of measures of economic activity. Using panel data methods we estimate a multiplier, defined as the change in per capita economic activity in response to an additional dollar per capita of federal funds. For personal income, which includes transfer payments as income, the estimate ranges from 0.91 for the combination of government grants and loans to 1.39 when only grants are considered. It is important to distinguish between the effects of farm subsidies and the combination of public works and relief grants. The personal income multiplier for public works and relief was around 1.67, while the effect of farm payments to take land out of production reduced personal income by 0.57. Multipliers for a more production-based measure of state income per capita after removing nonwork relief transfers and adding back payroll taxes are about 10 to 15 percent smaller. The multiplier for wages and salaries was substantially less than one, as was the multiplier for retail sales. The impact of the federal spending on employment was negligible and may have been negative. The results may help explain why measures of income have recovered more rapidly than measures of employment in both the 1930s and in the current era.

Get it? When the multiplier is “substantially┬áless than one,” then the federal spending is not having much effect on the economy. Literally, there is not much “bang for the buck.”